What is Financial Analysis?
Financial analysis refers to an assessment of the viability, stability, and profitability of a business, sub-business or project. It is performed by professionals who prepare reports using ratios that make use of information taken from financial statements and other reports. These reports are usually presented to top management as one of their bases in making business decisions.
As a business owner or the manager of a business you might want to develop a reward based system that would incentivize employees to be more efficient and simultaneously give them a quantifiable goal and purpose to achieve. Where would you begin your assessments of performance and how would you take and record these measurements? Hypothetically say that you ran a business and your current liabilities were skyrocketing. How would you know if you are keeping up with them? How would you determine or measure your likelihood of the business to be able to pay its current liabilities? This is where financial analysis became extremely useful to business managers as well as employees.
The term financial analysis refers to collecting the financial data for a business, and then making comparisons amongst different variables in either the same financial statement, across multiple financial statements, or across the business as a whole. Financial ratios allow business managers and investors to establish logical mathematical relationships between different variables (items) that are listed in the financial statements. The main source of financial information for a business will be the four primary financial statements, which are the balance sheet, the income statement, the statement of stockholders’ equity, and the statement of cash flows. The footnotes that the management team has included in their financial reports can also serve as a valuable source of qualitative information that helps to understand the thought process of the business owners or management team, as well as the future strategic direction for the business.
When performing financial analysis for a business it is important to examine and take into account other sources of data in addition to the financial statements for the business. The other sources of data that could potentially affect the specific business, the industry or sector specifically, or the economy as a whole will play a substantial role in understand a high-level macro overview of the current condition of a business, the trends that it is currently exhibiting, and the future direction for the business.
Financial analysis is performed by professionals who prepare reports using ratios that make use of information taken from financial statements and other reports. These reports are usually presented to top management as one of their bases in making business decisions. Financial analysis may determine if a business will:
- Continue or discontinue its main operation or part of its business;
- Make or purchase certain materials in the manufacture of its product;
- Acquire or rent/lease certain machineries and equipment in the production of its goods;
- Issue stocks or negotiate for a bank loan to increase its working capital;
- Make decisions regarding investing or lending capital;
- Make other decisions that allow management to make an informed selection on various alternatives in the conduct of its business.
How we got here?
The primary cause of the evolution of financial statement analysis can be traced back to the last stages of America’s drive to industrial maturity in the last half of the nineteenth century. As the management of enterprises in the various industrial sectors transferred from the enterprising capitalists to the professional manager and as the financial sector became a more predominate force in the economy, the need for financial statements increased accordingly. Both of these changes were primary causes of financial statement analysis.
But it was not the point from where it all began, if we move further back in the books of the history we can assess that from clay tablets to the cloud, accounting and finance have seen vast changes in tools, methods, and focus since their inception. But they continue to evolve in the face of a changing business environment.
Developments in the type and amount of data available to finance professionals, along with powerful new tools used to analyze it, have created a role for financial analysis. Evolving from reactionary to predictive has made finance a guiding hand for strategic business decisions—and senior leaders have begun to expect timely insights, creating pressure for teams.
In this blog post, we trace key historical developments that created the modern financial analysis function. As accounting dates back thousands of years and has been used and explored in many parts of the world. Given the importance of goods and trade to human civilization, it’s not surprising that bookkeeping and accounting date back to the beginning of recorded human history. Rudimentary accounting documents have been found in the ruins of Mesopotamia, Babylon, and other ancient civilizations dating back thousands of years. The earliest accounts of this language go back to Mesopotamian civilizations. These people kept the earliest records of goods traded and received. It was also related to the early record-keeping of the ancient Egyptians and Babylonians. They used more primitive accounting methods, keeping records that detailed transactions involving animals, livestock, and crops. In India, philosopher and economist Chanakya wrote “Arthashasthra” during the Mauryan Empire around the second century B.C. The book contained advice and details on how to maintain record books for accounts.
Bookkeepers most likely emerged while society was still in the barter and trade system (pre-2000 B.C.) rather than a cash and commerce economy. Ledgers from these times read like narratives with dates and descriptions of trades made or terms for services rendered. All the transactions were kept in individual ledgers, and if a dispute arose, they provided proof when matters were brought before magistrates. Although tiresome, this system of detailing every agreement was ideal because long periods of time could pass before transactions were completed.
As currencies became available and tradesmen and merchants began to build material wealth, bookkeeping also evolved. Then, as now, business sense and ability with numbers was not always found in one person, so math-phobic merchants would employ bookkeepers to maintain a record of what they owed and who owed them. Up until the late 1400s, this information was still arranged in a narrative style with all the numbers in a single column, whether an amount was paid, owed, or otherwise. This is called single-entry bookkeeping and is similar to what many of us do to keep track of our checkbooks. It was necessary for the bookkeeper to read the description of each entry to decide whether to deduct or add it when calculating something as simple as monthly profit or loss. This was a very time consuming and inefficient way to go about tallying things.
Known as the “Father of Accounting and Bookkeeping,” Italian mathematician and Franciscan friar Luca Bartolomeo de Pacioli described the double-entry accounting system in his 1494 book, Summa de Arithmetica, Geometria. Proportioni et Proportionalita. The system included most of the accounting cycle as we know it today and described the use of journals and ledgers, with account categories still used in balance sheets and income statements. Luca Pacioli revamped the common bookkeeping structure and laid the groundwork for modern accounting. Pacioli, in his book showed the benefits of a double-entry system for bookkeeping. The idea was to list an entity’s resources separately from any claims upon those resources by other entities. In the simplest form, this meant creating a balance sheet with separate debits and credits. This innovation made bookkeeping more efficient and provided a clearer picture of a company’s overall strength. This picture, however, was only for the owner who hired the bookkeeper. The general public didn’t get to see these records—at least not yet.
Later then bookkeeping migrated to America with European colonization. Although it was sometimes referred to as accounting, bookkeepers were still doing basic data entry and calculations for business owners. The businesses in question were small enough that the owners were personally involved and aware of the health of their companies. They didn’t need accountants to create complex financial statements or cost-benefit analysis.
The appearance of corporations in the U.S. and the creation of the railroad were the catalysts that transformed bookkeeping into the practice of accounting. Of the two factors, the railroad was by far the most powerful. To get goods and people to their destinations, you need distribution networks, shipping schedules, fare collection, competitive rates, and some way to evaluate whether all of this is being done in the most efficient way possible. Enter accounting with its cost estimates, financial statements, operating ratios, production reports, and a multitude of other metrics to give businesses the data they needed to make informed decisions.
The railroad also shrank the country. Business transactions could be settled in a matter of days rather than months, and information could be passed from city to city at a much greater speed. Even time did not run evenly across the country before the railroad. Previously, each township decided when the day began and ended by a general consensus. This was changed to a uniform system because it was necessary to have goods delivered and unloaded at certain stations at predictable times.
This shrinking of the country and introduction of uniformity encouraged investment, which, in turn, put more focus on accounting. Up to the 1800s, investing had been either a game of knowledge or one of luck. People acquired issues of stock in companies with which they were familiar, either by knowing the industry or knowing the owners, or they blindly invested where their relatives and friends encouraged them. There were no financials to check if you wanted to invest in a corporation or business that you knew nothing about. The risk of this type of investing made it an activity for the wealthy—a rich man’s sport with the taint of gambling. This image has never completely faded.
Obviously, there were many developments following this, but let’s fast-forward to the 20thcentury, when three major milestones laid the foundation for today’s accounting and modern finance functions.
In 1913, the U.S. ratified the 16th Amendment to the constitution, creating a federal income tax. The amendment forced individuals and companies to improve record keeping, but there was considerable confusion as to how this should be done.
As a result, in the Federal Reserve Bulletin of April 1917, the Federal Reserve issued ‘Uniform Accounting.’ While the bulletin purported to promote accounting uniformity, it left the majority of accounting choices to professional judgment.
Finally, following the stock market crash of 1929, the U.S. Congress passed the Security Act of 1933 and the Security Exchange Act of 1934. The acts prohibited deceit, misrepresentations, and other fraud in the sale of securities. It also established the Security and Exchange Commission (SEC), giving it broad powers to oversee and regulate the securities industry. The Exchange Act also empowered the SEC to require periodic reporting of information by companies with publicly traded securities.
Eager to attract more capital to expand their operations, corporations began to publish their financials in the form of a balance sheet, income statement, and cash flow statement. Investment capital from sources outside the company became more important than what was provided by the individual owners who had pioneered the business. Although bringing in this investment capital increased the range of operations and profits for most corporations, it also increased the pressure on the management to please their new bosses—the shareholders. For their part, the shareholders were unable to completely trust management, so the need for independent financial reviews of a company’s operations became apparent.
Accountants were already essential for attracting investors, and they quickly became essential for maintaining investor confidence. The profession of accounting was recognized in 1896 with a law stating the title of certified public accountant (CPA) would only be given to people who passed state examinations and had three years of experience in the field. The creation of professional accountants came at an opportune time. Less than 20 years later, the demand for CPAs would skyrocket as the U.S. government, in need of money they started charging income tax.
Technology has changed the way we look at accounting today. We no longer need to agonize over keeping detailed records of cash or commodity transactions by hand. Since the first records were kept in America, bookkeepers have used a number of different tools to help in their profession. The adding machine in 1890 helped early accountants calculate receipts faster, and they were able to quickly reconcile their books. When IBM released the first computer in 1952, accountants were among the first to use them. And recent advents in technology have taken accounting into the realm of computer software like Quickbooks. These new advancements are much more intuitive, helping accountants do their job quicker and with more ease.
These few points in history illustrate the foundation for the general practices of accounting, as well as the impetus for the modern accounting and finance function. But what about the ways modern financial analysis practices are accomplished?
There are two types of financial analysis: technical analysis and fundamental analysis. Technical analysis looks at quantitative charts, such as moving averages (MA), while fundamental analysis uses ratios, such as a company’s earnings per share (EPS).For example, technical analysis was conducted on the GBP/USD exchange rate after the results of the Brexit vote in June 2016. Looking at the exchange rate chart, it was determined that the rate dropped significantly after the vote on June 23, 2016, and then it recovered over a 48-hour period by 375 basis points (bps). And as an example of fundamental analysis, Discover Financial Services reported first-quarter 2016 results on July 19, 2016. The company had an EPS of $1.40, up from an EPS of $1.33 for the same quarter in 2015, which was a good sign.
How Technical analysis was invented?
The principles of technical analysis are derived from hundreds of years of financial market data. Some aspects of technical analysis began to appear in Amsterdam-based merchant Joseph de la Vega‘s accounts of the Dutch financial markets in the 17th century. In Asia, technical analysis is said to be a method developed by Homma Munehisa during the early 18th century which evolved into the use of candlestick techniques, and is today a technical analysis charting tool.In the 1920s and 1930s, Richard W. Schabacker published several books which continued the work of Charles Dow and William Peter Hamilton in their books Stock Market Theory and Practice and Technical Market Analysis. In 1948, Robert D. Edwards and John Magee published Technical Analysis of Stock Trends which is widely considered to be one of the seminal works of the discipline. It is exclusively concerned with trend analysis and chart patterns and remains in use to the present. Early technical analysis was almost exclusively the analysis of charts because the processing power of computers was not available for the modern degree of statistical analysis. Charles Dow reportedly originated a form of point and figure chart analysis. Dow Theory is based on the collected writings of Dow Jones co-founder and editor Charles Dow, and inspired the use and development of modern technical analysis at the end of the 19th century. Other pioneers of analysis techniques include Ralph Nelson Elliott, William Delbert Gann and Richard Wyckoff who developed their respective techniques in the early 20th century. More technical tools and theories have been developed and enhanced in recent decades, with an increasing emphasis on computer-assisted techniques using specially designed computer software.
How fundamental analysis was invented?
The history of fundamental analysis as a trading mechanism began with Benjamin Graham in 1928. Graham published his first book, Security Analysis in 1934. This book defined the framework of Value Investment and is now in its fifth edition. Since that time, a great deal of research focused on specific fundamental measures as key determinants of a securities future price. The concept of efficiency is central to finance. Mainly, in an efficient financial market an asset price should be the best possible estimate of its economic value. Fundamental analysis, in accounting and finance, is the analysis of a business’s financial statements (usually to analyze the business’s assets, liabilities, and earnings); health; and competitors and markets. It also considers the overall state of the economy and factors including interest rates, production, earnings, employment, GDP, housing, manufacturing and management.
Fundamental analysis is performed on historical and present data, but with the goal of making financial forecasts. There are several possible objectives:
- to conduct a company stock valuation and predict its probable price evolution;
- to make a projection on its business performance;
- to evaluate its management and make internal business decisions and/or to calculate its credit risk.
- to find out the intrinsic value of the share.
Difference between technical and fundamental analysis
Technical analysis maintains that all information is reflected already in the price of a security. Technical analysts look at trends and believe that sentiment changes predate and predict trend changes. Investors’ emotional responses to price movements lead to recognizable price chart patterns. Technical analysts also evaluate historical trends to predict future price movement. While Fundamental analysis maintains that markets may incorrectly price a security in the short run but that the “correct” price will eventually be reached. Profits can be made by purchasing the wrongly priced security and then waiting for the market to recognize its “mistake” and re-price the security.
What is Financial ratios and Financial Ratio Analysis?
Fundamental analysis is the process of looking at a business at the most basic or fundamental financial level. This type of analysis examines the key ratios of a business to determine its financial health. Fundamental analysis can also give you an idea of the value of what a company’s stock should be. Its most important tool is ‘Financial Ratio Analysis. Advanced cloud software like https://fintibi.wpengine.com/ is critical tools to achieve the said analysis
A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise’s financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization.
Financial Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick indication of a firm’s financial performance in several key areas. The ratios are categorized as Short-term Solvency Ratios, Debt Management Ratios, Asset Management Ratios, Profitability Ratios, and Market Value Ratios.
Financial Ratio Analysis as a tool possesses several important features. The data, which are provided by financial statements, are readily available. The computation of ratios facilitates the comparison of firms which differ in size. Ratios can be used to compare a firm’s financial performance with industry averages. In addition, ratios can be used in a form of trend analysis to identify areas where performance has improved or deteriorated over time.
Because Financial Ratio Analysis is based upon accounting information, its effectiveness is limited by the distortions which arise in financial statements due to such things as Historical Cost Accounting and inflation. Therefore, Ratio Analysis should only be used as a first step in financial analysis, to obtain a quick indication of a firm’s performance and to identify areas which need to be investigated further.
History of Financial Ratio analysis
In the beginning of nineteenth century essential improvement in ratio analysis occurred. In this period few developments are endogenous. First, large number of ratios was conceived in comparison to earlier periods. Second, proper ratio criteria were appeared. In this regard most famous was current ratio criterion. Third, different analysts understand the need of inter-firm analysis and for that purpose it felt the need for relative ratio criterion. Despite these developments ratio analysis has been used for analysis in this period and those felt the need of using ratio analysis only used current ratio.
Two very important exogenous developments in this period because of which need of ratios has surfaced were federal income tax code in 1913 and the establishment of the Federal Reserve System in 1914. These two developments also helped to improve the content of financial statements as well as increased the demand of financial statements.
In 1920s, interest in ratio analysis increased dramatically. Many publications on the topic of ratio analysis published during this period. Different credit agencies, trade unions, universities and individuals seeking analyses compiled industry data on ratio analysis.
Justin (1924) argued that the method of gathering industry data and calculates averages were called ‘Scientific ratio analysis’. The word ‘scientific’ in this title was not entirely correct because no evidence had been found that the hypothesis formulation and hypothesis testing actually carried out.
Horrigan (1968) says ratios analysis has come into existence since early ages and the main reason of the development of ratio analysis was its use in the analysis of the properties of ratios in 300 B.C. in recent time it is used as a standard tool for the analysis of financial statement. In nineteenth century main reasons of using ratio analysis are power of financial institutions and shifting of management to professional managers. Ratio analysis used for two purposes that are credit and managerial. In managerial approach profitability and in credit approach capacity of firm to pay debts is the main point of focus. Generally, ratio analysis is used credit analysis.
There was rapid expansion of financial knowledge in nineteenth century and to study this rapidly expanding knowledge analyst first compared similar items then moved further and compared current assets and liabilities as well with other ratios. In that period current ratio was the most significant ratio among all other available ratios. To analyze the operating results Dupont analysis is also used. The result divided into three parts and then compared with other companies to point out the problem and strong areas of business you can get the components of Dupont analysis by using https://fintibi.wpengine.com/.
Bliss (1923) says basic relationship within the business is indicated by the ratios and developed complete model based on the ratios. The purpose model was not mature but inspired others to start working on this theory.
Different critics of ratio analysis also appeared. Gilman (1925) has following concerns on ratio analysis (1) ratios are bond with time and changed as time passed so cannot be interpreted (2) ratios are not natural measure for judging the performance companies manipulated them (3) ratios easily affect the mind of viewers and hide the actual position and (4) ratios swing widely that also affect the dependability.
Foulke (1931) create and promoted own set of financial ratios successfully. This set of financial ratios was printed and promptly known as important and prominent group of ratios.
Fitzpatrick (1932) with the help of thirteen different type of ratios analysis 120 failed firms and found that three out of thirteen ratios predict the failure of firms with precise accuracy while other ratios also shown some prediction power.
Rasmer and foster (1931) used eleven ratios to examine that the successful firms has higher ratios than unsuccessful firms. Although this study was immature but immaturity was ignored by considering the vital contribution this study has in the evaluation of usefulness of ratios. Security and exchange commission of America was formed in 1934. This also expand the flow and number of financial statements and with the help of this peripheral factor importance of ratio analysis further enhanced and realized.
Marwin (1942) by using several ratios analyze financial trends of huge successful and unsuccessful firms. Compared normal ratios of industry with mean ratios of large unsuccessful firms and found out that the three ratios current ratio, net working capital to total assets and net worth to debt were able to foresee failure before actual failure happened. This study shows the real power of prediction of ratio analysis and results were still reliable.
Walter (1957) included cash flow statement items in ratio analysis. At the end of world war fund statement came into existence and with fund statement fund statement ratios was also produced.
Hickman (1958) used times interest earned ratio and net profit ratio to predict the default rate on corporate bond.
Saulnier (1958) says firms with low current ratio and debt ratio has greater chance to default then firms with high ratios.
Moore and Atkinson (1961) point out the relationship between capacity to pay and financial ratios and shows results of ratio analysis influence the borrowing ability of firms.
Beaver (1967) also examined the prediction power of ratio analysis and point out ratios ability to predict failure as early as five years before the collapsed. Statistical technique used in the study was more powerful than earlier studies and fund statement data was used to calculate ratio. This study set the foundation for future research on ratio analysis.
Sorter and Becker (1964) examined the relationship between psychological model and corporate personality of financial ratios and find out that long-established corporation maintain greater liquidity and solvency ratios.
Gombola and Ketz (1983) found that the fund and income statement are produced for different purpose and profitability ratios did not include the information that cash flow ratios provide. In other words both ratios gave important as well as different information from one and other.
In 1940s many nations expressed interest in ratio analysis. Current ratio has used in credit management in Australia after intense scrutiny. In England data has collected from different
organizations and sorted in ‘pyramid’ in order to used that data in ratio analysis so that decisions are made on more rational basis. In other wards British method is more management oriented than American system that is credit oriented. Indian and Canadian systems are similar to American system and the same kind of ratios and criteria has been used. In Japan data is available in grouping on the basis of industry and sizes of firms. China and Russia used several ratios as control measure in investment and working capital.
Pinches and Mingo (1973) evaluate the structure of ratios and found that ratios can be divided into different groups. Present general classification of financial ratios on logical basis. Results concluded that the ratios can be divided into four groups that are financial leverage, short-term capital intensiveness, return on investment and long-term capital intensiveness.
Stevens (1973) also studied the topic of ratio classification and grouped the financial ratios in four categories that include activity, liquidity, leverage and profitability.
Pinches, Mingo, and Caruthers (1973) and Pinches, Eubank, Mingo, and Caruthers (1975) carry on further worked on this subject and categorized the financial ratios in seven factors that include receivable turnover, capital turnover, short-term liquidity, return on investment, inventory turnover, financial leverage and cash position.
Libby (1975) also studies the division of financial ratios and condenses that division from seven to five. Five divisions include liquidity, activity, cash position, profitability and assets balance. Johnson (1979) further studies the research of Pinches (1973) and added another factor that is decomposition measure into seven factors.
Twelve different factors or division of financial ratios are presented in five different studies. On the basis of five published studies assortment of financial ratios are very time consuming because the results of published studies was very diverse.
Chen and Shimerda (1981) deeply examined five published studies and found out that some of the twelve factors that have been presented in the studies were the same and simply name is changed. Therefore, twelve factors are grouped into seven factors. Seven factors are cash position, financial leverage, inventory turnover, short-term liquidity, return on investment, receivable turnover and capital turnover.
Why fundamental analysis software is important?
In today’s world the use of financial ratios has increased. As it is very important to access the performance of firms by analyzing its liquidity, profitability, asset management, and efficiency ratios. These ratios help in following ways:
- Making informed decisions;
- Future forecasting;
- Analyzing financial statements;
- Helps in understanding profitability;
- Analyzing operational efficiency;
- Liquidity of firms;
- Helps in identifying business risks;
- Helps in identifying financial risks;
- To compare the performance of the firms;
- Financial planning.
Because of these important points, the need of fundamental analysis software has drastically increased. As today fundamental analysis software automates analysis that supports fundamental analysts in their review of a company’s financial statements and valuation. Financial analysis software such as https://fintibi.wpengine.com/ help companies monitor the financial performance of their business. This type of software is used to consolidate and compare financial transactions and accounting entries. Accounting departments leverage financial analysis software to ensure the accuracy of accounting data and to track financials, which can then be used to plan a company’s financial direction for the future. Accountants also use financial analysis software to generate reports and for financial compliance purposes. Finally, managers from other departments can also benefit from utilizing dashboards and reports that provide details on the financial performance of their teams.